As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
Are life insurance policy loans taxable?
A loan taken from a life insurance policy that is not classified as a modified endowment contract under IRC Section 7702A is not includable in income because it is not treated as a distribution under IRC Section 72.
By contrast, a loan taken from a life insurance policy that is classified as a modified endowment contract is treated as a distribution under IRC Section 72 and is includable in income at the time received to the extent that the cash value of the contract immediately before the distribution exceeds the investment in the contract. Unless the loan is made under certain specific circumstances, a 10 percent penalty tax is imposed on the amount of the loan that is includable in gross income.
If a loan is still outstanding when a policy is surrendered or allowed to lapse, the borrowed amount becomes taxable at that time to the extent the cash value exceeds the owner’s basis in the contract, as if the borrowed amount was actually received at the time of surrender or lapse and used to pay off the loan. If a loan is outstanding at the time of death, the distribution of the face amount of the policy usually is reduced by the amount of the outstanding loan.
Can a life insurance policy owner take an income tax deduction for the interest he or she pays on a policy loan?
To be deductible, interest paid by a policy owner on a policy loan must meet the rules discussed below. However, even if the interest is deductible under those rules, the amount of the deduction may be limited depending on whether the interest is classified as personal interest, trade or business interest, investment interest, or interest taken into account in computing income or loss from passive activities. Generally, the determination is made by tracing the use to which the loan proceeds are put. Thus, interest on a loan used to pay premiums on personal life insurance may come within an exception explained in but the deduction may not be available because personal interest is not deductible. There is little guidance as to whether interest on a loan used to buy life insurance can be considered investment interest. Borrowing to finance business life insurance generally has not been considered incurred in connection with the borrower’s trade or business.
General Rule of Nondeductibility for Policy Loan Interest
(Contracts Issued After June 8, 1997)
Generally, no deduction is allowed for any interest paid or accrued on any indebtedness with respect to life insurance policies owned by a taxpayer covering the life of any individual, or any endowment or annuity contracts owned by the taxpayer covering any individual. This provision generally is effective for contracts issued after June 8, 1997, in taxable years ending after this date. For purposes of this effective date, any material increase in the death benefit or other material change in the contract will be treated as a new contract. However, in the case of a master contract, the addition of covered lives is treated as a new contract only with respect to the additional covered lives.
The IRS has ruled that disallowed interest under IRC Section 264(a)(4) reduces earnings and profits for the taxable year in which the interest would have been allowable as a deduction but for its disallowance under that section. It does not further reduce earnings and profits when the death benefit is received under a life insurance contract.
General Rule of Nondeductibility for Policy Loan Interest
(Contracts Issued Prior to June 9, 1997)
For contracts issued prior to June 9, 1997, the general rule under IRC Section 264(a)(4) states that no deduction is allowed for any interest paid or accrued on any indebtedness with respect to life insurance policies owned by a taxpayer that covered the life of any individual who is an officer or employee of, or who is financially interested in, any trade or business carried on by the taxpayer. The same rule applies to any endowment or annuity contracts owned by a taxpayer that cover any individual.
Are there any exceptions to the nondeductibility rule for key-person policies?
The general nondeductibility rule does not apply to any interest paid or accrued on any indebtedness with respect to policies or contracts covering an individual who is a “key person” to the extent that the aggregate amount of the indebtedness with respect to policies and contracts covering the individual does not exceed $50,000.
A “key person” is an officer or 20 percent owner of the taxpayer. The number of persons who may be treated as key persons is limited to the greater of: (1) five individuals, or (2) the lesser of 5 percent of the total officers and employees of the taxpayer or 20 individuals. If the taxpayer is a corporation, a 20 percent owner is defined as any person who directly owns (1) 20 percent or more of the outstanding stock of the corporation or (2) stock possessing 20 percent or more of the total combined voting power of all of the corporation’s stock. If the taxpayer is not a corporation, a 20 percent owner is any person who owns 20 percent or more of the capital or profits interest in the taxpayer.
Generally, all members of a controlled group are treated as a single taxpayer for purposes of determining a 20 percent owner of a corporation and for applying the $50,000 limitation. This limitation is allocated among the members of a controlled group in the manner prescribed by the IRS.
Interest in excess of the amount that would have been determined had the “applicable rate of interest” been used cannot be deducted. The applicable rate of interest for any month is the interest rate described as “Moody’s Corporate Bond Yield Average – Monthly Average Corporates” as published by Moody’s Investors Service (the Moody’s Rate).
The Internal Revenue Code also specifies the manner in which to determine the applicable rate of interest for pre-1986 contracts. For a contract purchased on or before June 20, 1986 with a fixed interest rate, the applicable rate of interest for any month is the Moody’s Rate for the month in which the contract was purchased. If a contract with a variable interest rate was purchased on or before June 20, 1986, the applicable rate of interest for any month in an applicable period is the Moody’s Rate for the third month preceding the first month in such period. “Applicable period” is the twelve-month period beginning on the date the policy is issued, unless the taxpayer elects a number of months (not greater than twelve) other than such twelve-month period to be its applicable period. Such an election, if made, applies to the taxpayer’s first taxable year ending on or after October 13, 1995, and all subsequent taxable years.
If any amount was received from a life insurance policy, or endowment or annuity contract subject to IRC Section 264(a)(4), upon the complete surrender, redemption, or maturity of the policy or contract during calendar years 1996, 1997, or 1998 or in full discharge during these years of the obligation under the policy or contract that was in the nature of a refund of the consideration paid for the policy or contract, then the amount is includable in gross income ratably over the four-taxable-year period beginning with the taxable year the amount would have been included in income but for this provision.
How is interest expense allocated to life insurance policy cash values?
No deduction is allowed for the portion of the taxpayer’s interest expense that is allocable to unborrowed policy cash values. The portion that is allocable to unborrowed policy cash values is an amount that bears the same ratio to the interest expense as the taxpayer’s average unborrowed policy cash values of life insurance policies and annuity and endowment contracts issued after June 8, 1997, bear to the sum of: (1) the average unborrowed policy cash values, in the case of the taxpayer’s assets that are life insurance policies or annuity or endowment contracts, and (2) the average adjusted bases of such assets in the case of the taxpayer’s assets that do not fall into this category.
“Unborrowed policy cash value” is defined as the excess of the cash surrender value of a policy or contract (determined without regard to surrender charges) over the amount of any loan with respect to the policy or contract. For purposes of this provision, if the cash surrender value of a policy determined without reference to any surrender charge does not reasonably approximate its actual value, the amount taken into account is the greater of the amount of the insurance company liability or the insurance company reserve for the policy.
Are there any exceptions to the general rule of nondeductibility of policy loan interest for unborrowed policy cash values?
There is an exception to this general rule of nondeductibility of policy loan interest expense that is allocable to unborrowed policy cash values. The exception applies to any policy or contract owned by an entity engaged in a trade or business if the policy or contract covers only one individual who, at the time first covered by the policy or contract, is: (1) a 20 percent owner of the entity, or (2) an individual who is not a 20 percent owner but who is an officer, director, or employee of the trade or business. (A 20 percent owner is defined in IRC Section 264(e)(4).) A policy or contract covering a 20 percent owner will not fail to come within this exception simply because it covers both the owner and the owner’s spouse. Apparently, however, the policy will not qualify for this exception if spouses of officers, directors, or employees who are not also 20 percent owners are covered. For purposes of this rule, if coverage for each insured under a master contract (that is not a group life insurance contract) is treated as a separate contract for certain purposes, the coverage for each insured is treated as a separate contract.
The exception is effective generally for contracts issued after June 8, 1997, in taxable years ending after this date. For purposes of this effective date, any material increase in the death benefit or other material change in the contract will be treated as a new contract. However, in the case of a master contract, the addition of covered lives is treated as a new contract only with respect to the additional covered lives.
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